Euro zone bond yields tick higher with inflation in focus

By Harry Robertson

LONDON (Reuters) -Euro zone bond yields rose on Wednesday as investors digested a fall in inflation in the single-currency bloc, after a sharp drop Tuesday on the back of local German and Spanish data.

The year-on-year inflation rate in the euro zone slowed to 10% in November, according to a preliminary reading, down from 10.6% in October and below expectations for 10.4%.

Yet the core inflation rate, which strips out volatile energy and food prices, stayed at a record high of 5%.

Germany's 10-year government bond yield, seen as a benchmark for the bloc, was little changed after the data was released and was last up 3 basis points (bps) to 1.947%.

The yield fell 8 bps on Tuesday after German and Spanish inflation data came in below expectations, causing investors to expect a lower euro zone reading on Wednesday. Yields move inversely to prices.

With the headline inflation rate dropping but the core reading staying high, the euro zone data left a lot of questions unanswered, said Mauro Valle, head of fixed income at Generali (BIT:GASI) Investments Partners.

"There is no clear direction," he said. "The (market) sentiment is quite mixed at the moment."

Euro zone bond yields have shot up this year as the European Central Bank (ECB) has raised interest rates to tame inflation, causing investors to demand higher returns on government debt. Germany's 10-year yield started the year at around -0.2% but hit an 11-year high of 2.532% in October.

Economists said signs that inflation is turning a corner could cause the ECB to raise rates by 50 bps in December, after two consecutive 75 bp increases.

Commerzbank (ETR:CBKG) and ING both said the data increased the chances of a 50 bp hike. Consultancy Capital Economics said it remained a toss-up between 50 and 75.

"It's a very close call," said Generali's Valle. "There are a lot of factors, there is a lot of dependence on energy prices."

Germany's 2-year yield, which is more sensitive to ECB interest rate expectations, was up 4 bps to 2.136% on Wednesday, a level it has hovered around since late October.

Italy's 10-year yield was 6 bps higher at 3.88%. That took the gap between the German and Italian 10-year yields to 192 bps.

Investors also awaited a speech by Fed Chair Jerome Powell to the Brookings Institution on the economic outlook, scheduled for 1830 GMT.

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Global bond yields have dropped sharply since data earlier this month showed that U.S. inflation came in lower than expected in October, raising hopes the Fed's aggressive rate hikes may soon be over.

Yet ING rates strategist Antoine Bouvet cautioned that Powell could trigger a drop in bonds, and a rise in yields, by pushing back against those hopes.